The Volcker Rule's Role in the Muni Market

A reform aimed at Wall Street is taking a shot at the bonds states and localities issue.

Wild and wilder speculation brought Wall Street -- and the economy -- to its knees in 2008. That's why the Dodd-Frank Act, passed by Congress in 2010, aimed to tame Wall Street's excesses. One aspect of that law is the Volcker Rule. Proposed by Paul Volcker, the former chairman of the Federal Reserve, the rule restricts U.S. banks from making risky investments for their own profit (also known as proprietary trading) while the government guarantees their deposits.

Why is a rule that applies to Wall Street's rough and ready trading practices of concern to the staid municipal bond market? Because that rule would preclude the way banks buy and sell certain kinds of municipal bonds. A recent five-alarm headline put it this way: "Volcker Rule could prove to be 'devastating' for munis."

The Municipal Securities Rulemaking Board wrote a letter to the Securities and Exchange Commission (SEC) noting that proprietary trading in many markets is associated with dealers taking positions to try to profit from movements in a security. But in the highly illiquid $3.7 trillion municipal market, dealers are usually risking their own capital just to facilitate trades.

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"Underwriting and taking lead positions in new issues is a critical 'banking' function for the public sector," says professor John Allan James, executive director of Pace University's Center for Global Governance, Reporting and Regulation. In other words, if banks were precluded from proprietary trading in the muni market, they could no longer buy or sell certain kinds of muni bonds and make a market for them. By some estimates, nearly three-quarters of new bonds issued in 2011 were underwritten by banks that would have to follow the Volcker Rule, which goes into effect in July.

To learn more about the issue, I caught up with Washington state Treasurer James McIntire and Iowa Treasurer Mike Fitzgerald. Both had just returned from a few days in Washington, D.C., where they had gone to discuss the potential impact of the rule and the possible remedies. Here are some of the points they made:

The Volcker Rule affects some bonds and excludes others: "The concern I have is that they've used a very narrow definition of muni bonds [when applying exemptions]," says McIntire. "State and local government general obligation debt -- bonds issued by states and their political sub-divisions, such as counties and cities -- will be excluded from the ban. But debt issued by public agencies or authorities, such as special districts, would be subject to the restriction. State and local governments issue many different types of bonds to finance projects. Some of those bonds [most of which are revenue bonds, as opposed to general obligation bonds] are issued by special purpose districts like sewer or library, and others by conduit issuing authorities that provide access to tax-exempt financing for public purposes, such as providing loans for low-income housing, colleges and health-care facilities. Our concern is that the narrow definition doesn't make much sense."

Small issuers would be impacted the most: "A lot of the market would be hurt," says Fitzgerald. At risk, he says, would be port authorities and agencies that help businesses such as hospitals, or provide low-interest loans for housing agencies, students or farmer assistance. "The issues that aren't exempted will end up paying higher interest rates," he says. "Without the banks being able to make a market for the bonds, there will be less competition for selling their bonds."

"By driving up costs for taxpayers and rate payers in the public sector," McIntire adds, "the rule could have a very detrimental effect on investments in public infrastructure that many of us have felt could be and should be the core of economic recovery. The banks provide a beneficial framework for issuance. In particular, there are some smaller issuers whose debt the banks purchase. The banks have limits on how much they can purchase for their own accounts and how much they can hold. But the ability to make some purchases has helped smaller issuers place their fairly small issuances. Under the Volcker Rule, local banks might be banned from their ability to do that."

The secondary market could dry up: "When people buy these bonds, they rely on the secondary market," says Iowa's Fitzgerald. "If somebody buys an Iowa Finance Authority bond and three years from now, their circumstances change and they want to get out of the investment, they know they can sell in the secondary market. But if big firms are no longer making a secondary market, that makes those Iowa Finance Authority bonds less attractive. Iowa has a good reputation but with no bank to make a secondary market, it will be tough to sell those bonds. Knowing that, people will be less likely to buy them in the first place."

Efforts have been undertaken to exclude municipal bonds: "We've written to the SEC and the five agencies that enforce the Volcker Rule asking them to change this," says Washington state's McIntire. "When dealing with a committee of agencies, it's easy for each of those agencies to be imprecise in how they respond. We also have talked with representatives of the Treasury Department and the White House. We want a straightforward exclusion for municipal securities. While some may see this as a minor definitional issue, it's significant to us. It seems like a simple request, but a simple thing in Washington, D.C., is not always simple."